The Kool-Aid Factor

I think most of the pieces for understanding the current financial mess were in place well before the crisis occurred. If only they hadn't been ignored. We're not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them.

I would say that there is a sense in which Eric Maskin does not understand why the financial crisis took place, and he may never understand. It is not the case, as he implies, that regulators did not understand how banks provide liquidity or that their leverage requires regulation. The problems have more to do with institutions and adaptations, as I explain in Not What They Had in Mind.

One way to describe what Maskin is missing is what might be termed the Kool-Aid Factor. That is, regulators were drinking from the same Kool-Aid as the financial executives, believing that new financial instruments had dramatically lowered risk and made the system more stable. Danny Kaufmann calls this Kool-Aid factor "cognitive capture."

In Maskin's world, regulation is imperfect only if regulators are ignorant of economic theory or ideologically blind. In the real world, the Kool-Aid factor matters.

Comments and Sharing

BIS chief economist William White seems to have had enough of the elements in order to explain what happened before it happened -- but the Kool-aid drinkers wilfully ignored White's presentations to them.

Won't any financial regulation, short of industry destroying regulation, always lead to a bubble? Whether the regulation was right or not, over time, stability will lead to a belief that bubbles are no longer possible.

What the industry, the public, and the government do not want is instability, the kind that cleans out the system before a large bubble can develop.

By the time a recognizable bubble has developed, it is politically too late to do anything about it. Especially this time, with large numbers of lower income people riding zero-down ninja loans into the middle class. Of course, the bubble popped anyway, but the political class responsibility is at one remove, rather than immediate, and can now be positioned, with breathtaking chutzpah, as "lack of oversight".

"regulators were drinking from the same Kool-Aid as the financial executives"

Actually, they were all drinking the Kool-Aid of mainstream financial economics, which teaches that money is neutral. As a result, they didn't see the damage to the structure of production that massive monetary pumping causes. They think it only causes bubbles in assets or cpi growth.

Bank execs followed Basel I & II to the letter and invested most of their money in AAA and AA-rated securities. You can't get much more conservative than that. And the MBS's they invested in were AAA and AA.

What mainstream econ didn't see, and therefore the regulators and CEO's didn't see it either, was that the Feds monetary pumping caused overbuilding in housing, not just over pricing. Some people, like Krugman, thought housing was overpriced but they didn't see that it was over built as well.

In addition, the false security of the AAA and AA ratings given by the ratings agencies encouraged CEO's to over leverage, but they could over leverage only because the Feds pumped in so much new money.

There has been a trend in investment banking and hedge funds for decades to invest in highly conservative investments with AAA and AA ratings and then goose the returns with extremely high leverage. It seemed impossible to lose with that strategy. What they didn't count on was everyone heading for the exits at the same time.

Why is what you say any different from what Maskin says? He says regulators "ignored" the relevant information; you say they "drank the Kool Aid." So they drank the Kool Aid and ignored the information. Do you really want to disagree with his conclusion? "We're not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them."

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